Dynamic Agency and the Q Theory of Investment

70 Pages Posted: 30 Apr 2012  

Peter M. DeMarzo

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Michael J. Fishman

Kellogg School of Management - Department of Finance

Zhiguo He

University of Chicago - Booth School of Business, and NBER

Neng Wang

Columbia Business School - Finance and Economics

Date Written: April 29, 2012

Abstract

We develop an analytically-tractable model integrating the dynamic theory of investment with dynamic optimal incentive contracting, thereby endogenizing financing constraints. Incentive contracting generates a history-dependent wedge between marginal and average q, and both vary over time as good (bad) performance relaxes (tightens) financing constraints. Financial slack, not cash flow, is the appropriate proxy for financing constraints. Investment decreases with firm-specific risk, and is positively correlated with past profits, past investment, and managerial compensation even with time-invariant investment opportunities. Optimal contracting involves deferred compensation; possible termination; and compensation that depends on exogenous observable persistent profitability shocks, effectively paying managers for luck.

Suggested Citation

DeMarzo, Peter M. and Fishman, Michael J. and He, Zhiguo and Wang, Neng, Dynamic Agency and the Q Theory of Investment (April 29, 2012). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2048039

Peter M. DeMarzo

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1082 (Phone)
650-725-7979 (Fax)

HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Michael Jay Fishman

Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States
847-491-8332 (Phone)
847-491-5719 (Fax)

Zhiguo He (Contact Author)

University of Chicago - Booth School of Business, and NBER ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/zhiguo.he/pubs.html

Neng Wang

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

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